Your form of business is a part of the way you present yourself to the marketplace. Deciding what type of ownership form you should use requires a lot of thought and some help from your financial advisor(s). Without a thorough knowledge of your personal and family financial situation and goals, no one can tell you the best form to use. When you seek advice from your financial planner, attorney and/or accountant, expect many questions about your personal and family aspirations and financial goals. If those kinds of questions are not forthcoming, your advisor is not doing you a good service and you might wish to with someone else.
Part of the decision will be based on how much self-employment tax you may or may not have to pay. If you earn $1,000 in wages working for a company, you pay 7.65% ($76.50) in social security and Medicare taxes. Your employer must match your contribution with an additional 7.65%. So, the US government (IRS) receives a total of 15.3% in social security and Medicare taxes for every dollar of wages paid. (i.e. half from the employee, the other half from the employer.)
In many cases, if you are self employed, the IRS requires that you pay the entire 15.3% yourself since there is no employer to match your 7.65% contribution. It is possible to structure your business, under certain conditions to help minimize the amount of this self-employment tax you have to pay, however, you have to be sure to pay a certain amount over time so that you will be eligible for social security and/or Medicare benefits in the future. Whatever your strategy, be sure to put money back—maybe even in a separate account—to pay your self-employment tax. It is crucial that you have the money when it comes due.
When you do choose an ownership form that helps minimize the self-employment tax, be aware the IRS has strict rules you must follow in order to stay eligible. They don’t like the idea of you avoiding payment of the other half of the self-employment taxes.
Here are some snippet notes for each of the ownership forms to supplement the information presented in the
Business Entity Comparison Chart.
Sole Proprietorship (SP)
This is the easiest to use. You “hang out your shingle” to do a certain type of business. You should have separate bank accounts and keep separate records of your business income and expenses. Profits and losses from the business are combined with your other income and reported on your personal tax return. You are considered the sole owner of any company assets and you are responsible for any company liabilities (i.e. debts). If things go bad, creditors will have access to all of your personal assets including those that have nothing to do with your business; you have unlimited liability for your business debts. There is no opportunity to save any self-employment tax with this form of ownership.
General Partnership (GP)
This was one of the early ways for two or more partners to go into business together. Profit and losses may “pass through” to or are directly reported on each partner’s form 1040. Partners own company assets and are responsible for company liabilities. Both partners may have equal management responsibilities, but not necessarily. One partner could secretly obligate the company to a huge liability and the other partner is obligated and responsible to pay the debt. For this reason, general partnership is rarely used for small business ventures. If things go bad, creditors will have access to all of the partners’ personal and family assets including those that don’t have anything to do with the business. There is no opportunity to save any self-employment tax with this form of ownership.
Limited Liability Company (LLC)
This is a newer form of ownership than the general partnership. Members of the LLC are called unit holders. Profit and losses “pass through” to each unit holder’s form 1040. Each unit holder has some protection from liability caused by other unit holders. Unit holders’ personal assets are somewhat protected from creditors, however, note that most lenders will require members to sign a personal guarantee which makes each member personally responsible to pay back the loan. There is a very limited opportunity to save some self-employment tax with this ownership form.
The LLC may be a single-person entity. If so, it is generally recognized by the IRS as a sole proprietorship, although single-person LLC’s do afford some asset protection.
S-Corporation (S-Corp)
This is a corporation (a corporation is a separate legal entity owned by stockholders) for which the IRS has given permission for profits and losses to pass through to each stockholder’s form 1040. Stockholders may have some protection from the liabilities of the corporation; however, most lenders will require personal guarantees in order to secure financing. There may be an opportunity to save some self-employment tax with this ownership form. The IRS will expect you to follow the rules regarding corporations; including having an annual meeting with minutes, even when there is only one stockholder.
C-Corporation (C-Corp)
For the ownership forms above, income taxes are payable only one time. The C-Corporation is the only ownership type subject to double taxation. The corporation pays a tax on profits through the corporation’s own tax return. Working stockholders take wages out of the corporation in return for their work on behalf of the corporation. Those wages are subject to stockholders’ personal tax liability on their forms 1040. This double taxation feature usually makes it an unattractive option for most small business owners, however if a business is expected to lose money for several years before having good profit years, it can be advantageous. The IRS will expect you to follow the rules regarding corporations; including having an annual meeting with minutes, even when there is only one stockholder.
With the tax advantages of some of these ownership forms also comes the responsibility to make sure you fulfill the requirements imposed by state and federal rules. For instance, corporations must hold annual stockholder meetings (even if there are only one or two stock holders) with minutes of the proceedings. Corporations are subject to bylaws created for the particular corporation. The bylaws must be followed. Failure to follow the rules can result in the IRS declaring that you are not really the tax advantaged entity you proclaimed. If they determine you are not the entity you claimed, you may be liable for many of the tax savings your were trying to accomplish when you created the entity in the first place.
This information is provided for general information purposes only. Some specialized partner ownership forms are not presented here as they are beyond the needs of most small businesses. Ownership form decisions are complex and should only be made with the help of a trusted, experienced advisor.
©2009-2010 Jim Correll, Successful Entrepreneur Program, Independence Community College
